Eurozone Bailout for Spain Hobbled by Technicalities

In its scramble to get ahead of the sovereign debt crisis and shore up Spain's struggling banks before Greek elections, Europe may well have succeeded in tying itself in knots.

While a positive move in principle, the eurozone's offer to lend Spain up to 100 billion euros ($125 billion) to recapitalize its banks could even worsen its problems because of growing doubts about the wisdom of holding Spanish debt.

After the briefest of relief rallies, investors have already cast their verdict, pushing 10-year Spanish borrowing costs to their highest level since the launch of the euro on Tuesday — not the impact eurozone ministers were hoping for.

The uncertainty stems from where the currency bloc is going to source the money to lend to Spain.

It can either lend from its temporary bailout fund, the European Financial Stability Facility, or from its permanent rescue fund, the European Stability Mechanism, which is scheduled to come into force next month.

The crux of the problem is the different legal standing of loans made from the 440-billion-euro EFSF and those that will be made from the ESM, which once fully capitalized will have 500 billion euros.

Germany, France, the Netherlands and other wealthier eurozone countries want the loan to come from the ESM, which has 'preferred creditor status', meaning it must be paid back before other creditors such as private investors.

No surprise then that those investors are heading for the exit having seen the losses handed to creditors as part of Greece's second sovereign bailout.

Eurozone officials are alive to the problem and have said the money could come from the EFSF initially and then be transferred into the ESM, while holding on to the same legal status it would have had in the temporary fund.

The net result is confusion in financial markets.

"There's that fundamental problem — if you're a bondholder and they just push you down the line, why would you invest in Spanish government bonds?" said Gary Jenkins, director of Swordfish Research Ltd, specialist in fixed income research.

"What they should be doing is trying to encourage people to invest in Spain, not discourage them," he said.

Rising bond yields mean that it will be even harder for Spain to fund itself in the market, something that the eurozone wants Madrid to keep doing.

In turn, adding up to 100 billion euros more to Spain's debt pile — nearly 10 percent of the country's gross domestic product — will increase its debt-to-GDP ratio to more than 90 percent, well above a normally manageable level.

The rising borrowing costs will also increase the interest payments it has to make, which must come out of its annual budget, driving up the deficit at a time when the country is in recession and expected to remain there through 2013.

In sum, a bailout designed to shore up Spain's weakest banks, stricken with billions of euros of bad property loans and other underperforming debt, may end up saddling the country with even more debt and less chance of paying it off.

Market sentiment could yet be turned because the eurozone has not definitively decided if the loan will come from the EFSF or ESM. But the question mark is out there and the answer may end up depending on exactly when Madrid decides to make a formal request for the money.

TIMING

Spanish officials have said they first need to get the results of a privately commissioned audit of its banks to know how much money is needed. That audit, by the consultancies Oliver Wyman and Roland Berger, is due around June 21.

Since the ESM is only expected to become operational on July 9, after the German parliament ratifies it, any request for aid before then will have to come from the EFSF.

A rapid request is expected in large part because the June 17 Greek elections threaten to cause more market turmoil, particularly if the far-left coalition wins and delivers on its promise to renege on the country's bailout terms.

If the Spanish loan, or the first tranche of it, is requested before the ESM goes online, the money will have to come from the EFSF and the debt seniority problem would be resolved — at least for a short period of time.

Another reason why many eurozone countries would prefer the ESM to handle the bailout is that, unlike with the EFSF, loans extended from the ESM do not increase the individual debt levels of those countries helping to save Spain.

Use of the ESM would bypass the tricky question of whether Spain, if it borrows from the EFSF, should at the same time cease to be a guarantor of the fund because it is a country which itself needs help.

It would also sidestep the problem of Finland, which can only participate in new bailouts from the EFSF if it gets collateral from the beneficiary country to match the Finnish contribution. There is no such condition for ESM bailouts.

The sheer complexity of the formal and political requirements for the bailout after two years of the sovereign debt crisis has left officials battling to come up with a convincing solution that is also simple to implement.

One under discussing is to let the EFSF issue the first tranche of the Spanish bailout before July and for the ESM to take over the rest of the program later.

Under the ESM treaty, existing financing programs taken over by the ESM from the EFSF do not acquire the right to be paid back first, so investor concerns should ease.

At the same time the debt of eurozone countries guaranteeing the EFSF would only increase by the amount of the first tranche and Finland could join the Spanish bailout once it is taken over by the ESM, without getting any collateral.